First American Money Market Funds

What market conditions had a direct impact on the bond market this quarter?

Economic Activity – The U.S. economy continues to perform well this year, exceeding expectations and defying traditional signals of recession. Following above-trend growth of 3.0% in the second quarter, U.S. Gross Domestic Product (GDP) is projected to grow near 2.0% for the third quarter (Q3) amid still-firm domestic demand and business investment. Personal consumption was steady throughout Q3 as income growth helped offset persistent headwinds from elevated prices and high interest rates. Labor market conditions cooled early in the quarter but rebounded in September, ending Q3 largely where it began, with August U.S. job openings stable at 8.0 million open positions while total unemployed workers in the labor force as of September were unchanged at 6.8 million. Monthly Non-farm Payrolls growth accelerated, averaging 186,000 during Q3 and the U3 Unemployment Rate was 4.1% in September, matching the level from June. Average Hourly Earnings growth is off its highs but remains elevated at 4.0% year-over-year (YoY), emphasizing still-solid labor demand. The Consumer Price Index (CPI) declined to 2.5% in August versus 3.0% in June as energy prices fell throughout the quarter. Core inflation continued its gradual downward trend with CPI ex. food and energy rising 3.2% YoY for August compared to 3.3% YoY in June. The Federal Reserve’s (Fed) preferred inflation index – the PCE Core Deflator Index – increased 2.7% YoY for August. While recent data has been encouraging, the inflation fight is not over as progress remains mixed, driven by core goods deflation. Further disinflation in core services and housing will be necessary to ultimately achieve the Fed’s 2% target and desired soft landing.

Monetary Policy – The Fed cut its federal funds target range by 50 basis points (bps) to 4.75% to 5.0% at the September 18 meeting. While a rate cut in September was fully expected by the market, expectations were split between 25 and 50 bps. The Fed’s post-meeting statement was updated to say the Committee has “gained greater confidence” inflation is moving toward its 2% target and risks to inflation and employment are judged as “roughly in balance.” The Fed continues to implement its balance sheet reduction program (quantitative tightening), with a monthly cap of $25 billion in Treasury securities and $35 billion of agency mortgage-backed securities. During the press conference Chair Powell stated at this point they are not thinking about stopping quantitative tightening as they cut rates, noting the two can happen in tandem and are both forms of normalization.

The Federal Open Market Committee (FOMC) released its updated Summary of Economic Projections at the September meeting, indicating additional rate cuts are coming. The median projection for the federal funds rate at the end of 2024 was revised to a range of 4.25% to 4.50%, signaling 50 bps of rate cuts for the remainder of this year. The median dots also show rate cuts of 100 bps in 2025 and 50 bps in 2026, leading to a terminal neutral rate of 2.875%. The FOMC’s economic projections were revised to show forecasts for a higher unemployment rate at the end of the year compared to the prior release (4.4% vs. 4.0%) and slightly lower core inflation and GDP growth. The unemployment rate forecast was also increased by 0.2% compared to the prior release for both 2025 and 2026 while revisions to inflation and GDP were minimal. While the median funds rate projections are helpful to understand Fed officials’ current expectations, the near-term pace of easing will ultimately be dictated by the labor market given the Fed’s desire to limit further weakening.

Fiscal Policy – The federal government once again narrowly avoided a shutdown at the end of September with Congress passing a continuing resolution to fund government operations at existing spending levels through December 20. Fiscal policy action will be muted over the near-term as Washington D.C.’s focus fully shifts to the upcoming elections, but should pick up later this year as Congress will need to come to an agreement on a funding bill for the full fiscal year and the U.S. government debt ceiling will be reinstated January 1, 2025.

Looking further out, government spending is anticipated to increase, with both political parties campaigning on increased fiscal policy initiatives and tax incentives. Recently passed bills for the Infrastructure and Jobs Act (2021) and Inflation Reduction Act (2022) will also boost government spending over the long-term. On the municipal side, state and local governments that are more heavily reliant on sales and property taxes are faring better than municipalities dependent on income taxes, but strong reserves have left the overall sector in a solid position should economic conditions weaken further.

Credit Markets – U.S. Treasury yield curve levels plunged as markets digested the Fed’s 50 bps rate cut. The yield curve steepened in the quarter, with the two- to 10-year portion of the yield curve disinverting for the first time since July 2022. Credit spreads were modestly tighter in the quarter as investor demand for yield and spread product kept pace with heavy new issue corporate supply. As a result, third quarter fixed income total returns were strong across all sectors and duration bands.   

Yield Curve Shift

Duration Relative Performance

*Duration estimate is as of 9/30/2024

With the path for Fed rate cuts uncertain, yield curve volatility was, and is. expected to remain elevated, placing a premium on identifying tactical extension opportunities. The decline in rates benefitted longer duration strategies over shorter portfolios.

Credit Spread Changes

Option-Adjusted Spread (OAS) measures the spread of a fixed-income instrument against the risk-free rate of return. U.S. Treasury securities generally represent the risk-free rate.

Corporate credit spreads entered the quarter relatively tight from an historical basis, but still managed to further tighten on the margin. Accordingly, corporates debt outperformed comparable duration treasuries. Bucking the trend, triple-A asset-backed securities (ABS) spreads widened in the quarter, leading to underperformance in the quarter versus corporate debt. With valuations slightly more attractive than investment-grade credit, the ABS sector will be a focus for increased allocations coming into the fourth quarter. 

Credit Sector Relative Performance of ICE BofA Indexes

ICE BofA Index

*AAA-A Corporate index outperformed the Treasury index by 8.7 bps.

*AAA-A Corporate index underperformed the BBB Corporate index by 14.9 bps

*U.S. Financials outperformed U.S. Non-Financials by 7.6 bps

U.S. financials outperformed non-financial corporate debt primarily due to its higher coupon advantage, as spreads for both sectors remained roughly unchanged. BBB credit outperformed AAA-A credit as demand for spread product and corporate debt remained strong in the quarter.      

What were the major factors influencing money market funds this quarter?

The second quarter of 2024 continued with the FOMC on hold and the market taking a moderately dovish tone as economic and employment data and inflation gauges softened on the margin. The Fed left rates unchanged at a range of 5.25% to 5.50% at the June 12 meeting and indicated they now anticipate one 25 bps cut by year-end. Fed fund futures are a bit more dovish, forecasting 50 bps in rate cuts in 2024. There are a wide range of opinions on the timing of future rate activity, and the challenge for managers going forward is determining how the economy and inflation will influence FOMC action.

Money market fund assets continued to increase during the quarter as elevated money market yields attracted investors. With the Fed focused on price stability, money market funds remain an attractive investment option for fixed income investors.

First American Prime Obligations Funds

Credit conditions and trading ranges appear stable given the current rate environment. Given the yield curve and our conservative cash flow approach, the First American Funds were positioned with strong portfolio liquidity metrics influenced by Fund shareholder makeup. We continued to employ a heightened credit outlook, maintaining positions presenting minimal credit risk to the Fund’s investors. During the second quarter, our main investment objective was to maintain liquidity while opportunistically enhancing portfolio yield based on our economic, credit and interest rate outlook, along with considerations of investor cash flows. We believe the credit environment and higher relative fund yields make the sector an appropriate short-term option for investors.

First American Government and Treasury Funds

Treasury bill/note/dealer repo supply expanded as the Fed continued quantitative tightening and overall debt needs increased. Front-end Treasuries provided a marginal yield pick-up, providing government and treasury money market funds with a repo substitute. With the Fed on hold and their next move most likely a downward move in rates, managers extended durations, investing in longer-term securities to get ahead of a forecasted lower yield environment. The extension into lower yielding long-term securities has put marginal downward pressure on portfolio yields. When presented with appropriate value, we also purchased floating-rate investments designed to benefit shareholders over the securities holding period. Our investment strategy will be fluid in the coming quarters as markets make determinations on the Fed’s comfort level with inflation and, ultimately, the timing and pace of future rate moves.   

First American Retail Tax Free Obligations Fund

Tax-exempt money market fund industry-wide assets continued to trend upward, reaching a nearly five-year high of more than $130 billion in early June. Resets on variable rate demand notes (VRDNs) were approximately 30 bps higher on average versus Q1. The Securities Industry and Financial Markets Association (SIFMA) index spiked above 4% multiple times, as broker/dealers reacted to various events, including tax season and quarter end. Municipal notes with one-year maturities saw yields rise by about 15 bps, primarily due to diminished expectations for Federal Reserve easing. Portfolio management continues to be focused on positioning the Fund with higher allocations to fixed rate securities and a longer weighted average maturity (WAM) versus its peers. This strategy reflects our expectations that heavy reinvestment from municipal bond and coupon payments may likely drive VRDN resets lower over the coming months. Further, we consider the yield costs of protecting against economic weakness as relatively low, and we believe the Fed reaction function is now more tilted to those type of easing scenarios.        

What near-term considerations will affect fund management?

Industry-wide, prime fund yields have probably peaked and will gradually fall as managers roll maturities into flat to lower-yielding securities that are pricing in the possibility of future rate cuts. Compression in credit spreads will also narrow SOFR floating rate coupons putting marginal downward pressure on portfolio yields. However, broadly speaking, front-end yields in credit securities should continue to benefit from the overall supply increase in Treasury securities, as well as the reduced demand from impending money market fund reform, creating competition among credit issuers for the marginal dollar. However, we believe that the Institutional Prime Money Market class is small enough that the overall impact will be muted. Based on our market outlook and breakeven analysis, in the coming quarters we will seek to capitalize on investment opportunities that make economic sense. We believe the Institutional and Retail Prime Obligations Funds will remain reasonable short-term investment options for investors seeking higher yields on cash positions while assuming minimal credit risk.

Yields in the government-sponsored enterprise (GSE) and Treasury space will remain influenced by Fed policy and Treasury bill/note supply. With front-end yields elevated and the Fed still wary of inflation, the investment environment for government money market funds should remain attractive. As with non-government debt, government and Treasury fund yields have probably peaked and will continue to gradually decline as managers roll maturities into securities with lower yields that are pricing in future rate reductions. We anticipate some moderate yield dislocations in Treasury and GSE issues as the influx of bill supply and continued quantitative tightening increase competition as bonds look for a home away from dealer balance sheets. Any large supply changes in Treasury issuance may create yield volatility on the front-end as the forces of supply and demand seek optimization. Investors may also decide to opportunistically invest in term securities, extending durations, as markets attempt to solve the timing and pace of future Fed policy. We will continue to seek value in all asset classes and exploit market conditions that support domestic and global economic outlooks.

For more information about the portfolio holdings, please visit 

https://www.firstamericanfunds.com/index/FundPerformance/PortfolioHoldings.html

Sources

Bloomberg

https://about.bgov.com/brief/the-presidents-fy25-budget-request/

https://www.federalreserve.gov/monetarypolicy/files/monetary20240501a1.pdf

https://www.federalreserve.gov/monetarypolicy/files/monetary20240612a1.pdf

https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240612.pdf